Real Estate is being disrupted faster than what you think

Commercial rent collection is one of the world’s oldest industries. In fact renting out farms is where it all started and many of the terms we still use today - landlord, tenant, improvements and yield - originate from agriculture. Commercial real estate is an industry beset by manual processes and little technology. It’s also an extremely conservative industry, that assumes demand will always be there.

But commercial real estate is now changing rapidly. From high street retail to office blocks, industrial plants to shopping malls - what has worked for half a century is now at a critical inflection point. A storm of global trends are coming together at the same time to cause real disruption to real estate.

Corporate investment in the sector was historically built around large-scale diversified portfolios of income producing real estate assets, backed by 10-year or 15-year leases that investors acquired and managed on the basis of reliable long-term income. In South Africa, the industry was uniquely boosted by compounding annual rental escalations - often ahead of inflation rates. Commercial real estate has always been an ideal investment for financial investors: stable assets generating predictable growing returns that are easy to exit.

For 100 years developing, selling, investing, lending, leasing and managing commercial real estate was a perfect way to make piles of money. Apparently 223 billionaires, about 10% of the world’s richest people, made their fortunes from real estate.

Yet, over the last few years the foundations of this lucrative model has increasingly come under serious threat. Every industry changes, even slow-moving conservative sectors like real estate investment. Describing where retail or office real estate is headed, or even where it currently stands, is difficult.

From on-line retail, to cloud kitchens, from co-working offices to flexible warehousing - real estate is now rapidly changing and looking unpredictable for investors. Just the idea that lease periods around the world are getting shorter and shorter is scaring investors and lenders.

But today any company in the world cannot plan more than two years ahead and many don't want long term commitments. Furthermore a multitude of factors is allowing the end-users of real estate to have an abundance of choice in terms of where, when and how to work, live, shop or store their wares.

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‍One must never forget that the value of retail, office and industrial assets is a function of their ability to generate revenue for the businesses who use them.

For shopping malls the erosion in values has been cataclysmic. The once darling of the real estate industry is now looking increasingly fragile. A potent cocktail of the shift to online shopping, rising costs for retailers who run brick-and-mortar stores, improved last-mile delivery, stock control technology and a reluctance among consumers to actually shop in shopping centres has led to financial difficulties at national retail chains, hitting the very heart of the retail real estate business model. Retail brands are no longer reliant on physical stores to be the only platform to get their products to customers.

In a sign of growing concern leading US real estate consultants Green Street recently warned that shopping malls were facing a “death spiral”. Shopping mall values have dropped about 30 per cent since a peak in values was reached three years ago.

A staggering number of stores shut down in 2019 - over 9,000, way up from the 5,800 that closed in 2018. And already in 2020, more than 1,250 retail locations have gone dark. When giant retailers like Macy's, Sears, Bed Bath & Beyond, CVS & Walgreens, Bose, Victoria's Secret, Gap, Forever 21, Office Depot, KMart, TopShop and Hallmark Cards have collectively closed thousands of shops – it's past questioning whether the entire brick-and-mortar retail industry is facing disruption from changing consumer behavior. The change has arrived at a store near you.

Traditional customers are simply no longer visiting malls, or at least not at historic rates, and many of the malls where these mega brands were located are dead or dying.

South Africa is not immune to global trends. We are just slower in responding to structural demand and supply changes (just look at how long its taken to shut down bankrupt South African Airways). Its no surprise that American-owned Massmart are the first local retailers to announce 34 store closures at their DionWired and Masscash retail stores. More are probably coming.

Massmart is yet to give details on the possible downsizing of its Game stores, which has around 130 outlets, but their new CEO, Mitch Slape, questioned high rentals and escalations which he recently slated as being "ridiculous". Although yet to recover from Edcon’s woes, South Africa’s shopping centre landlords are set to face intense rental negotiations with other major retailers.

In the past investors, owners and managers of shopping malls relied on ever-rising rental income from the business tenants, as well as the ever increasing value of their property portfolios – but they are now obviously worth a lot less and many shopping mall owners will struggle to reinvent themselves.

It was inconceivable a few years ago that large established corporations like Edcon and Massmart could become the most unstable tenants of all and are proving to be landlords' biggest risk. Where it all ends is a question that many shareholders of listed property are not waiting around to answer. Plummeting share prices are their response.

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Office blocks are facing larger disruption

It's safe to say that traditional office buildings are dying out. The empty office blocks dotted around Sandton and Rivonia are evidence of not only a cooling economy but a structural demand-side change. The phenomena of emptying office blocks is simply another global trend. Large offices, like large shopping malls are an invention of the past century. The factory arose because of powered machinery, which required workers to be gathered in one place. Big offices grew from the need to process lots of paperwork, and for managers to instruct clerks on what to do. But now the internet, personal computing, cloud services and handheld devices mean that administrative functions can be dealt with on-line and managers can instantly communicate with their workers and customers, wherever they are. The head count of clerical staff has been steadily dropping as technology continually replaces manual administrative processes. The need for large offices and other types of real estate spaces that have worked for decades has been dramatically reduced.

While the WeWork IPO and its valuation as a tech company may have been a disaster, let’s not forget that WeWork revolutionised the length of office leases. Today no-one wants very long office leases. The environment is too unpredictable for anything else.

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What landlords offer and what tenants want are becoming diametrically opposed

WeWork operates over 2 million square metres of office space. It draws over $4 billion in annual revenue. It generates this revenue not by subsidising its customers (as tech companies like Uber does), but by charging a premium on every square metre it leases from landlords. Even if WeWork will never be profitable, even if WeWork is worth only $10, $5, or $1 billion, even if WeWork goes bankrupt — the office market will never be the same. WeWork’s death will not halt the transformation of the office sector. Office end-users want service, they want flexibility, and they want to interact with a brand that stands for something.

The WeWork's of this world, and there are many, are showing the growing diversion between what landlords offer and what tenants want. Landlords offer spaces that require high tenant installation costs, while tenants want limited capital costs. Landlords offer a variety of confusing and unpredictable recoverable charges, while tenants want simplicity and clear predictable monthly costs. Landlords offer long fixed-term leases with onerous default consequences, while tenants want flexible terms with multiple options if their business needs to change or are not performing. Landlords offer fixed annual rental escalations, while tenants want performance-based escalations or price reversions. Landlords offer outsourced service providers and property managers, while tenants want a single point of contact with ongoing retail-like customer service.

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Real estate is shifting away from being an industry governed by low-touch financial managers that thrive on well-run assets to an industry governed by high-touch operators that thrive on well-run businesses

The shift is most visible in retail but is applicable to all the real estate classes. Part of this complexity is due to the thickening layer of service required by tenants. And tenants increasingly want a turnkey solution. The growing popularity of flexible short-term leases is undermining the operating model of real estate’s traditional institutional investors: many buildings are becoming less like fixed-income products, and more like an operating business.

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The value of retail, office, residential, and industrial assets is a function of their ability to generate revenue for their tenants.

Value is increasingly not just about quantity, quality, location or even rental price. If landlords can help businesses generate revenue they will grow in a disrupted environment. Landlords that offer services focusing on their customer’s specific needs can attract tenants to new locations and command higher rents than neighbouring buildings who just offer commoditised space on a rate per square metre basis.

To offer superior products and services, real estate companies will be forced to integrate different components into a value chain that benefits their customers. The value of integration gives great advantages to players who can bring actual buildings, technology, services and operating platforms under one roof.

Real estate investor Blackstone, for example, has invested in or acquired an energy management software company, a leasing technology company, a serviced office and hospitality platform, and a single-family home rental and customer service platform. This gives it great advantages against competitors who only own buildings. Part of the reason Blackstone is doing it, is to protect its own position as a fund manager for institutional investors.

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So much is happening in real estate right now. The industry is in serious flux.

The pace of change is accelerating. Is it possible for traditional real estate companies to thrive in such an environment? Most real estate owners need to realise that they are like any other business operation. They may have been a unique asset class. But those days are over. Now they will need to provide brand, services, customer value, experiences, ease, simplicity and realise that tenants are like any other demanding customer.

TEN IDEAS TO SURVIVE DISRUPTION

Inospace is an owner and operator of serviced business parks that provide innovative industrial, office and storage spaces overlaid with a range of business benefits. Our mission is to support businesses through offering our clients flexibility, affordability, community and simplicity.

So, here are ten lessons that we have discovered and used at Inospace:  

GET TO KNOW OUR CUSTOMER: Not just the entity that signs the lease. Not “one size fits all”. Not “if you build it - they will come”. We need to know OUR customers. A tenant is a customer, so we need to understand their needs and what they are trying to achieve.

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CONSIDER THE WHOLE VALUE CHAIN. The value of integration brings advantages to players who can bring actual space, services and operating platforms together. The full value chain for our tenants is immense and we continually search and implement value-adding services which go way beyond space-per-square metre.

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SIMPLIFY THE LEASING PROCESS. If the leasing process is annoying or slow — someone can step in and take your customer away. We have made leasing quick, simple and easy because that is what customers want today. They don’t want complex one-sided agreements that are outsourced to external service providers to draw up.

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GROW A BRAND WITH MEANING. As we grow our real estate platform, we benefit from the power of a brand. Not a brand for the sake of it but brand that has meaning. A brand that addresses customer’s needs and says something about us and about our customers.

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USE THE DATA THAT YOU HAVE. We are starting to consolidate and analyse what information we have, using new tools to gather more data. And this doesn’t mean infringing on our client's privacy but we are finding ways to understand our buildings, how they are used and what our customers are doing in them.

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LEVERAGE OUR NETWORK: We realised that if we have many business parks (now 25) – we have a network. We can leverage this network because there are different ways to create value out of offering a range of locations to our customers. Like regular hotel guests we want our customers to feel like they are part of a membership and not stuck to one space in one location.

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CHANGE THE MANAGEMENT TALENT POOL. We must diversify our talent pool. If we want to change an industry, we must be cautious of hiring from that industry. We think that "landlordism" is dead and we are don't want property managers who believe that they are at the top of the real estate value chain, and those who see real estate only in yield calculations.

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GET BACK TO BASICS. Corporate activity, funding structures, investor relations and yield calculations are an end-game. These corporate activities don't fill spaces or assist customers. So we rather spend our time looking at the bread and butter of real estate: leasing, service, maintenance management and basic issues about how easy is it to purchase electricity or book a meeting room or move in and out of premises.

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HAVE A CLEAR STRATEGY. The industry is going to be transformed. We have a strategy which we regularly revisit. We also have a house view about the markets we operate in. Since the market is being disrupted our strategy often comes from the people who interact daily and directly with our clients (that's why we don't outsource sales, collections and property management). Our strategy drives our core business offering, and that comes from what our clients want and need.

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LOOK AT FUNDING DIFFERENTLY. Traditional investors are shying away from traditional commercial real estate players. The days of cobbling together a disparate group of assets, getting someone else to manage them and spending time on capital raising - are over. We believe that ultimately, the capital stack for companies may be a combination of venture capital (to finance tech and product development) as well as real estate equity, debt and bank financing.

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